Problem Set 3 -- Solutions

1. Define quasi-rents. Provide a real-world example of a situation where
quasi-rents exist. Under what circumstances would the quasi-rents in your
example be appropriable, and what incentive problems might this cause?

Quasi rents are payments in excess of the amount needed to keep an
asset in its current use. Quasi-rents often exist with respect to
parking garages. Whatever their next best use is (rollerblading rink?
skateboarding palace?), it is much less valuable than as a parking garage.
Most of the money parking garage operators receive is quasi-rents since
what they would receive in its next best use is low. You effectively
rent space when you pay for parking. Most of what you pay is quasi-rents.

However, it is unlikely that much of the quasi-rents would be appropriable
by you, because the parking spaces are equally valuable to other users.
The quasi-rents would only be appropriable if all or most potential parkers
banded together and collectively renegotiated the parking rate. (For
example, with respect to UCLA's garages, all faculty, students and staff.)
If this were the case, you could bargain the parking lot manager down to
what the "next best user" would be willing to pay. If the parking
lot manager anticipated this, he or she might not build the parking lot
in the first place, even though it may be value-maximizing to do so.

Several pieces of information will be useful to you. First, the two
biggest variable cost items on trucking firms' balance sheets are labor
and fuel. Second, "OTR" stands for "on the road" and the pay scale is in
cents per mile, where mileage is defined by the shortest distance between
drivers' origin and destination. Third, the "current random OTR" was their
former pay scale -- one that was about the same as most other trucking
firms. "2/25/97 Random OTR" is the new pay scale. Fourth, trucking firms
have been under increased pressure from shippers and receivers to pick
up and deliver loads on tighter schedules.

Different elements of this compensation program can be explained using
several different theories we have come across in class.

What are J.B. Hunt's objectives? What are individual drivers' objectives?
How do they conflict?

J.B. Hunt's objectives are to maximize profits. Toward this goal,
they may choose to offer high quality service to their shippers, and they
wish to minimize their costs of production, given the quantity and quality
of service they offer. Individual drivers seek to maximize utility,
which is increasing in their income and decreasing in their effort.
They choose effort toward producing higher quantities and toward how they
drive. The objectives conflict because drivers bear the full cost
of their effort but generally do not receive the full benefits. Hence,
they will tend to shirk both on quantity (taking longer breaks) and in
how they drive (possibly more recklessly, or in a way that does not conserve
on fuel).

What choices that drivers make influence the extent to which J.B. Hunt
achieves its objectives?

How fast they drive, how long the breaks are, how carefully to drive,
how much to help load/unload their truck, etc., etc.

Describe the most important elements in the compensation program as you
see it. How do they align drivers' incentives with those of their firm?
Is J.B. Hunt using explicit performance incentives? Is it using efficiency
wages to provide incentives?

I see two important elements. First, they are paying explicit
performance incentives. They pay drivers by the mile. The faster
the drivers reach their destination, the higher wage/hour and the more
hauls they can fit in during the day. This serves to improve incentives
with respect to quantity -- drivers will take shorter breaks and may help
load or unload trucks. However, this may encourage them to drive
more recklessly or in a way that wastes fuel.

The other element is that the per-mile wages are higher than at other
firms. They are paying above the competitive wage, and this facet
of the compensation scheme has an "efficiency wage" feel to it. Paying
above a competitive wage does two things. Losing a job at JB Hunt
is now costly to drivers. The threat of firing creates stronger incentives
for drivers not to shirk in general -- to take shorter breaks, drive in
a way that conserves fuel (assuming fuel consumption can be measured),
etc. Another thing that paying above a competitive wage does is reduce
turnover. Workers will be more reluctant to quit. This decreases
total labor costs if it is costly to train new drivers.

Do the different elements of this compensation program complement each
other? Why or why not? Do you see any specific problems with this plan?
If so, what are they?

The efficiency wage aspect complements the explicit performance incentives
because it provides incentives for drivers to exert effort toward things
other than quantity. Explicit performance incentives generally discourage
activities other than what is being directly compensated. The efficiency
wage aspect counters this.

I do not see any problems immediately. But if other trucking
firms decide to match JB Hunt's compensation package, the efficiency wage
aspects will not be as effective and this would tend to undermine the value
of paying strong performance incentives. (There may be other problems
I do not see at this point -- and I am eager to see what you write.)When answering these questions, feel free to make any additional assumptions
not in the article or the problem, but state them clearly.

3. According to Hart, what defines a firm? Using Hart's theory, explain
why GM faced a hold-up problem with Fisher Auto Body during the 1920s,
even though GM owned 60% of Fisher's shares. Also using Hart's theory,
explain how vertical integration between GM and Fisher alleviated this
incentive problem.

A firm is defined by the common ownership of assets used in production,
where the owner(s) of an asset is the individual(s) that has residual control
rights over it. For example, the scope of AT&T is defined
by the set of assets for which its shareholders have residual control rights.

Using Hart's theory, having 60% of Fisher's shares may not have meant
that GM had residual control rights over all Fisher's assets. This
created a hold up problem because Fisher could threaten to withdraw the
assets for which it had residual control rights from the trading
relationship. It may have been able to appropriate the value of any
relationship-specific investments made by GM. Vertical integration
transferred residual control rights of Fisher's capital assets to GM, thus
eliminating the ability of Fisher's management to withdraw these productive
assets from the trading relationship. GM's relationship-specific
investments were more protected from appropriation.

4. Recently, franchisees have brought suit against franchisors, claiming
that contractual provisions which limit who they can purchase inputs from
are unfair trade practices. Provide an efficiency explanation for such
practices. Suppose Congress passes a law prohibiting such provisions in
all new franchisor/franchisee contracts. How would you expect contracts
between franchisors and franchisees to change as a result? That is, what
other contractual provisions would you expect to change?

Efficiency explanation: limiting who they can purchase inputs
from may economize on costs associated with monitoring quality.Contract changes: The contract would stipulate alternative means
of monitoring quality -- perhaps by providing for more frequent store visits,
etc. In order to compensate whomever is directly bearing these greater
monitoring costs, franchise fees and/or royalties would be adjusted.
For example, if the franchisor directly bears the cost of additional monitoring,
then franchise fees and or royalties would increase.

If the efficiency explanation is correct, such a law would tend to
make both franchisees and franchisors no better off than they were before
the law, and would make at least one of them worse off.